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 | June 2019


                                      
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Greetings - 

After a strong rally over the first four months of the year, stocks pulled back in June with the S&P 500 giving back 6.35% and the NASDAQ surrendering nearly 8.0%. The cause: rising tensions with China over trade.

While we agree that volatility is likely to remain elevated until there is more clarity, it's hard to bet against this economy as the fundamentals are strong with unemployment, growth, interest rates and inflation all in the sweet spot.

Market pullbacks like we saw in May are most often a healthy pause in an ongoing bull market. It is our expectation that when a trade deal with China is reached that markets around the world will explode to the upside in a new leg up for this bull market.

Let's discuss.
Economy - Perspective

In May we attended a First Trust event during the "China Selloff" where CEO Jim Bowen, CIO Dave McGarel and Chief Economist Brian Wesbury offered their take on the markets and economy. While we don't like to parrot the remarks of those trying to sell us something, we found many of their comments consistent with our own research and worthy of sharing. Here's what they had to say: 

1. CEO Jim Bowen is bullish on the American economy and productivity. He lampooned all the critics who were crying about record levels of corporate debt last December during the crash. Bowen noted we also have record levels of corporate assets and that corporate assets are growing faster than debts. The stock market is driven by corporate profits. As long as those are rising, the stock market should rise.

2. Bowen talked about our productivity gains. For example, it used to take 70 days to frack a well. Now it takes 10 days. Oil production per rig is 5X today what it was 10 years ago. EIA keeps increasing their crude oil production forecasts. From 2015-17, they were at 9-10M Barrels per day in 2023. Revised to 11M in 2018. Revised to 14M in 2019.  We will be net exporters of oil in 2020.

3. Bowen spoke about manufacturing output increases. America is the place to be for complex manufacturing. For example, all the BMW SUVs are made in South Carolina. He spoke about cancer research and how deaths per 100,000 have dropped from 110 in early 1990s to 80 today. We have seen significant reductions in breast and prostate cancer mortality rates.

4. CIO Dave McGarel spoke next. Contrarian by nature.  MaGarel talked about valuations of the Top 50 S&P stocks being much higher (price to book, sales, earnings, cash flow) than the valuations of the 450 other S&P stocks. He talked about a probable rotation back into value.  While growth as outpaced value by nearly 3% per year over the last decade, value has outperformed growth by 3% per year over the last 90 years. He likes the financial sector. McGarel closed with the thought that volatility is the emotional price long term investors pay for returns.

5. Chief Economist Brian Wesbury concluded.  He talked more about American productivity and GDP growth, and said the world is dramatically changing in our favor. Cutting corporate tax rates from 40% to 27% essentially removed a subsidy to foreign nations, and they are not happy about it.  Wesbury speculated that reduced tax rates encouraging investment in America may be one cause for the so-called slower global growth. Now we are going after another subsidy: tariffs (and stolen IP).  He said China's average tariff has come down from 9.8% to 7% since the negotiations began, but the media doesn't report it.  Channels like CNBC have to play to their audience, which are currently bearish people worried enough about their money that they watch financial news. China's tariffs on energy are zero because they need it. They hate having to rely on America for energy like we hated having to rely on the Arab nations. But they've got to have it. The real bargaining chip with China is the supply chain. If they lose the supply chain because companies pull out, it will cripple their economy for generations. They have to keep the supply chain, so Wesbury thinks they will capitulate in the negotiations.

6. Finally, Wesbury doesn't see a recession.   Over the last 50 years, recessions start when the Fed gets too tight as defined by the Fed Funds rate compared to 2 year annualized nominal GDP growth (real growth + inflation). Right now, the Fed is at 2.4% and two year nominal GDP growth is near 5%. Contrary to some, he doesn't think the Fed will cut rates. According to Wesbury, the neutral rate is about 4.5% (or half a percent below 2-year nominal GDP growth).
Technical Picture

The S&P 500 has corrected back to its 200-day moving average. This is not uncommon in bull markets, especially after the big run up we had in the first four months of the year. As the charts below depict, the 200-
day moving average has ended several selloffs in recent years. Where the market got in trouble in late 2018 was when the S&P traded below its 200-day moving average (red box in the second chart).

So far, the 200-day moving average has held. We are monitoring it closely and stand ready to hedge our portfolios if the market rolls over and heads south of the 200-day average.








In Closing

In the midst of all of this the Federal Reserve remains in pause mode; after becoming significantly more dovish since the January Federal Open Market Committee meeting. As demonstrated in the CME Fed Watch Chart below which is based on futures trading, the Fed rate is currently 225-250 basis points, with the market expecting two more rate cuts (36.2%) by December.  And interestingly, the market currently believes it three rate cuts (29.3%) are more likely than one (20.0%).   

In our opinion, the  economic data would have to deteriorate much more for a rate cut to come to pass near-term, much less two rate cuts.  It is encouraging to see however that the Fed now may be willing to address global trade fears with a more dovish stance.  Indeed, Fed Chairman Powell said today that the Fed is prepared to act appropriately to sustain expansion. 
 


"The best way to destroy an enemy is to make him a friend."   Abraham Lincoln

Sincerely,

Marty Kerns
President & Chief Executive Officer
Parker Binion
Chief Investment Officer
About Kerns Capital Management
Kerns Capital Management is a leading asset management firm with a focus on quantitative, liquid alternative investment strategies, including the KCM Macro Trends Fund.  We are value-oriented investors in long/short equity, credit and volatility, and apply the same attention to risk in the deployment of capital that has guided us since our inception as a fiduciary investment manager to corporate pensions, trusts and high net worth individuals.  Kerns was founded in 1996, and is based in Houston, Texas.

For more information on our products, including fund performance, please visit www.kernscapital.com or contact Martin Kerns or Parker Binion at 1 (800) 945-2125 or  ir@kernscapital.com
IMPORTANT DISCLOSURES

Performance data represents past performance and is not a guarantee of future results.   Performance current to the most recent month-end may be lower or higher, and can be obtained by calling 800-945-2125.

Marty Kerns, KC M's Chief Compliance Officer, remains available to address any questions regarding this performance presentation, including its limitations.  Mr. Kerns can be contacted via email at  marty@kernscapital.com  or toll-free at 800.945.2125 .

The S&P TR 500 Index is an unmanaged composite of 500 common stocks. This index is widely used by professional investors as a performance benchmark. Total return includes reinvestment of dividends. You cannot invest directly in an index. The Dow Jones Industrial Average is a price-weighted average of 30 of the largest and most widely held stocks traded on the New York Stock Exchange and the Nasdaq. The Nasdaq Composite Index is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depository receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The iShares Core U.S. Aggregate Bond Index is an ETF (AGG) that seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. The Morningstar Moderate Target Risk Index is based on a well-established asset allocation methodology from Ibbotson Associates, a Morningstar company and a leader in the field of asset allocation theory. The securities selected for the asset allocation indexes are driven by the rules-based indexing methodologies that power Morningstar's comprehensive index family. Morningstar indexes are specifically designed to be seamless, investable building blocks that deliver pure asset-class exposure. Morningstar indexes cover a global set of stocks, bonds, and commodities.